What will a deepwater recovery look like for contractors?

In the five years since the 1996 bill became law, telecommunications companies poured more than $500 billion into laying fiber optic cable, adding new switches, and building wireless networks. So much long-distance capacity was added in North America, for example, that no more than two percent is currently being used. With the fixed costs of these new networks so high and the marginal costs of sending signals over them so low, it is not a surprise that competition has forced prices down to the point where many firms have lost the ability to service their debts. No wonder we have seen so many bankruptcies and layoffs.

Brookings Institute, 2002

McKinsey Energy Inisghts has a good article on how a recovery in the offshore energy might play out. The article makes the point I have made here that large deepwater projects, especially in Brazil and the Gulf of Mexico, are likely to economically attractive going forward but smaller, and shallower projects are in trouble.

First let’s appreciate the scale of the downturn the offshore contracting and supply industry is dealing with:

Global upstream investment has suffered dramatic cuts in the recent low oil price environment. Upstream oil and gas capex was halved from ~$800 billion in 2014 to ~$400 billion in 2016, and global exploration and appraisal spending fell by 40% to $11.2 billion during the same period…

Spending cuts are expected to cause a 50-60% decrease in oil volumes coming online from new projects in the next three to five years, compared to the 2010-14 average. As with brownfield projects, the greenfield pipeline for the next few years has been significantly reduced due to the lack of investment since 2014, especially for shallow water developments. [Emphasis added].

So if you own a shallow water asset, like a DSV for example, this massive drop in demand is proportionately harder. Mckinsey say $654bn will need to be invested in currently unsanctioned projects by 2030, but that doesn’t come close to replacing the level of spending cut. Obviously a greater volume of work is being delivered for a greatly reduced price, which is one of their key points. Having predicted a supply gap in the oil market I also thought this prediction was interesting:

Projects that reached FID before 2014 – including mega-projects such as Lula and Golden Eagle – will cover 60% of the anticipated supply gap in 2020-21…

This is an industry with a long run supply curve. Talk of “inflection points” from some contractors just don’t seem to be backed by data.

Read the whole thing. I have a broader point than simply doing a cut and paste from McKinsey but it is based on this:

As a result of cost compression, deepwater breakeven levels are likely to continue being 20-25% lower than 2014, despite a situation where oil prices increase to $70/bbl in our base case. The wider margin created by lower costs should place deepwater investments firmly at the left side of the global oil cost curve, making these projects viable to close the supply gap.

McKinsey see the cost reductions in the offshore supply chain as permanent and structural. Not all relate to oversupply, but they are all based on spending less time offshore.

Although not as widely reported a bigger investment boom than the Dot Com investment bubble was the telecoms investment bubble that occurred at roughly the same time. The global, but particularly US, industry was overcapitalised as companies laid the “dark fibre” of the future internet. A vast number of firms went bankrupt and were subject to fraud (remember Bernie Ebbers and Worldcom?) before they even “lit” the fibre. It was a speculative mania in an industry that like offshore had very high fixed-costs and very low marginal-costs. But the thing is the telecoms companies made nothing from the boom, shareholders and bondholders were largely wiped out, the same thing happened in the English railway mania of the 1840s, and an earlier canal boom in the 1790s which ended in 1793 (and here). The winners from the telecoms investment boom have been companies like Netflix, Google, and Facebook which have used the networks paid for earlier at well below their true economic cost (and without the coordination issues of splitting the installation costs between themselves), similar arguments can be made for railways and canals. The net private losses were potentially an overall social gain.

So the question really is has the offshore industry just supplied a huge amount of latent capacity that will allow E&P companies to close the supply gap cost effectively while wiping out the equity of those who built the infratsructure behind it? I hope pre-2016 Seadrill shareholders (amongst others) enjoy their quality viewing, direct from the internet, and appreciate the irony.

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